Greenspan - the Wizard of Bubbleland 

Henry C.K. Liu

This article appeared in Asia Times on September 14, 2005

The Kansas City Federal Reserve Bank annual symposium at Jackson Hole, Wyoming is a ritual in which central bankers from major economies all over the world, backed by their supporting cast of court jesters masquerading as monetary economists, privately rationalize their unmerited yet enormous power over the fate of the global economy by publicly confessing that while their collective knowledge is grossly inadequate for the daunting challenge of the task entrusted to them, their faith-based dogma nevertheless should remain above question.  That dogma is based on a single-dimensional theology that sound money is the sine qua non of economic well-being. It is a peculiar ideology given that central banking as an institution derives its raison d’etre from the rejection of a rigid gold standard in favor of monetary elasticity.  In plain language, central banking sees as its prime function the management of the money supply to fit the transactional needs of the economy, instead of fixing the amount of money in circulation by the amount of gold held by the money-issuing authority. Thus central bankers believe in sound money, but not too sound please, lest the economy should falter. Their mantra is borrowed from the Confessions of St Augustine: “God, give me chastity and continence - but not just now.”

This year, the annual august gathering in August took on special fanfare as it marked the final appearance of Alan Greenspan as Chairman of the Federal Reserve Board of Governors. Among the several interrelated options of controlling the money supply, the Federal Reserve, acting as a fourth branch of government based on dubious constitutional legitimacy and head of the global central banking snake based on dollar hegemony, has selected interest rate policy as the instrument of choice for managing the economy all through the 18-year stewardship of Alan Greenspan, on whom much accolade was showered by invited participants in the Jackson Hole seminar in anticipation of his retirement in early 2006.  Greenspan’s formula of reducing market regulation by substituting it with post-crisis intervention is merely buying borrowed extensions of the boom with amplified severity of the inevitable bust down the road. The Fed is increasingly reduced by this formula to an irrelevant role of explaining an anarchic economy rather than directing it towards a rational paradigm. It has adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan’s monetary approach has been when in doubt, ease.  This means injecting more money into the banking system whenever the economy shows signs of faltering, even if caused by structural imbalances rather than monetary tightness.  For almost two decades, Greenspan has justifiably been in near-constant doubt about structural balances in the economy, yet his response to mounting imbalances has invariably been the administration of off-the-shelf monetary laxative, leading to a serious case of lingering monetary diarrhea that manifests itself in run-away asset price inflation mistaken for growth.

Paul Volcker, as chairman of the Fed before Greenspan, caused a “double-dip” recession in 1979-80 and 1981-82 to cure double-digit inflation and in the process, bringing the unemployment rate into double digits for the first time since 1940. Volcker then piloted the economy through its long recovery that ended with the 1987 crash.  To his credit, Volker did manage to bring unemployment below 5.5%, half a point lower than in the 1978-79 boom, and the acknowledged structural unemployment rate of 6%. To achieve his heroic, albeit bloody victory over intractable inflation, Volker adopted a “new operating method” for the Fed in 1980 as a therapeutic shock treatment for Wall Street, which had been spoiled fearless by the brazen political opportunism of Arthur Burns, Volcker’s predecessor during the Nixon-Ford era.  Wall Street had lost faith in the Fed’s political will to control inflation. The new operating method concentrated on managing monetary aggregates to levels deemed appropriate for a given state of the economy, and let them dictate Fed funds rate (FFR) swings to be authorized by the Fed Open Market Committee (FOMC).  For 1980, this meant a FFR within a range from 13-19% in the context of double-digit inflation. This new operating method was an exercise in “creative uncertainty” to shock the financial market out of its complacency about the Fed’s tradition of interest rate stability and gradualism. The market had developed a habitual expectation that even if the Fed were forced by inflation trends to raise interest rates, it would not permit the market to be volatile, lest the political wrath from both the White House and the Congress should threaten its existence. Banks could continue to create money through lending as long as they could profitably manage the gradual rise in rates, foiling the Fed’s policy objective of slowing the growth of the money supply to contain inflation.

Volker’s new operating method reversed the traditional mandate of the Fed, which, as a central bank, was supposed to be responsible for maintaining orderly markets, meaning smooth, gradual changes in interest rates. The new operating method was an attempt to induce the threat of short-term pain to stabilize long-term inflation expectations. The reversal was necessary because the market had come to expect the Fed to only gradually raise interest rates keep even an unbalanced economy from collapsing. Targeting the money supply generates large sudden swings in short-term interest rates that produce unintended shifts in the real economy that then feed back into demand for money. The process has been described as the Fed acting as a monetarist dog chasing its own tail. Unlike the Keynesian formula of deficit financing to reduce unemployment in a down cycle, the Fed’s easy money approach since the Nixon administration had been to channel the funny money to the rich who need it least, rather than to the poor who would immediately spend it to sustain aggregate demand to moderate the business cycle. This supply-side easy money approach led to an economy of overcapacity, with idle plants unable to profitably produce goods for lack of consumer demand. Say’s law, that supply creates its own demand, is inoperative unless there is full employment, which sound money deems undesirable.

Greenspan’s measured-paced interest rate policy is a reversal back to the Fed’s tradition of gradualism.  The trouble with a measured-paced interest rate policy in a debt-driven economy of overcapacity is that the debt cancer is spreading faster than the gradual doses of medical radiation can handle. Yet fatality is a poor trade-off for the avoidance of hair loss from radiation.  Greenspan’s measured pace represents a lack of political courage to acknowledge that it is preferable by far for the finance sector to take a huge haircut preemptively than for the whole economy to collapse later.  Moral hazard is increased unless risk takers in the finance sector are made to bear the consequences of their actions, and not be allowed to pass the pain from risk onto the economy at large.

All economists agree that when money growth slows, market interest rates go up. Yet the emergence of unregulated credit markets has cast doubt of the reverse causal effect.  Rising interest rates no longer necessarily slow money growth. Often it merely makes money growth more costly to accelerate asset price appreciation, curiously defined by economists as growth, not inflation. This is particularly true with short-term rate which is the only rate that can be set directly by the Fed.  An excessively low short-term rate encouraging banks to borrow short-term to lend long term to try to profit from the interest rate spread. Also, the trouble with the use of the FFR target to control money supply was that it had to be set by fiat, which exposed the Fed to unwanted political pressure for interrupting the boom. A case can be made, and is frequently made, that the Fed’s FFR target tends to be a self-fulfilling prophecy rather than a device to manage future trends. High FFR targets deflate while low targets inflate, and there is little argument about that relationship beyond the dispute on the definition of inflation. Because Greenspan had no hesitation in lowering the FFR target in a less-than-measured pace to reverse asset deflation in the 2000 recession, and again in the summer of 2003, his subsequent measured pace in bringing the FFR target back above inflation rate represents an act of policy cowardice.<>

Market demand for new loans, expressed as the pace for new lending, obviously would not be moderated by raising the price of money, as long as the inflation/interest gap remains profitable. Yet bank deregulation diluted the Fed's control of the supply of credit, leaving price of short-term funds (interest rate) as the only operational lever. Price is not always an effective lever against runaway demand, as Greenspan found out in the 1990s. Raising the price of money to fight inflation in a debt economy is by definition self-neutralizing because high interest cost is itself inflationary in a debt economy. Deregulation also allows the price of money to allocate credit in the market, often directing credit to where the economy needs it least, namely the speculative arena where borrowers are more prepared to pay high rates.

The Fed might have in its employ a staff of very sophisticated economists who understood the complex multi-dimensional forces of the market, but the tools available to the Fed for dealing with market instability was single-dimensional by ideology and design. Measured-paced interest-rate policy was the only weapon available to the Fed to tame an aggressively unruly market that increasingly viewed the Fed as a paper tiger.

The Fed protects itself from criticism of ideological bias in its decision-making by depriving the public and its critics of timely information paid for by tax money. The Fed remains above criticism because its decisions are always based on more current information on the economy than that available to the market, decisions that the market would understand only if it had the same information, although the rationale for depriving the market of the latest information on the economy in the age of instant communication and political transparency has never been made clear.

According to the Minneapolis Fed, aside from the color of their covers, the Fed’s Red and Beige books differed in one important way: the Red Book was prepared for policymakers only, and was not intended for public consumption. The Red Book became public in 1983 after a request by the longtime representative from the District of Columbia, Walter Fauntroy, for public release of the Green Book, which contains the Fed’s closely-held national models and economic forecasts. The Fed deemed this unwise and the Red Book was offered in its place. To mark the change, the color red was dropped in favor of beige (it was for a time also called the Tan Book). To detract from the implied importance of the document in FOMC policymaking, the public release of the Beige Book, published eight times per year containing anecdotal information on current economic conditions in all twelve districts through reports from Federal Reserve District Banks and Branch directors and interviews with key business contacts, economists, market experts, and other sources, is timed for two weeks prior to an FOMC meeting, so that the media and others would recognize that the information contained in it is dated and, therefore, does not have a major influence on future policy. The Fed’s power of decision is not based on a better understanding on how the economy works than market participants, but on more timely and privileged information. The rationale for keeping the Green Book from public view has never been explained, so much for policy transparency in a democratic society.  Perhaps, as Greenspan has been saying recently: the state of the art of economic forecasting is far from reliable, thus there is no harm keeping it from the public.

And there is plenty of argument about the Fed’s projection ability on the economy. History has shown that the Fed, more often than not, has made wrong decisions based on faulty projection. Greenspan has been rightly criticized for letting a housing price “bubble” develop, equating it to the one that swept technology stocks to stratospheric levels before bursting in 2000. Greenspan argues the Fed’s role is to mop up after bubbles burst, since bubbles are hard to spot and deflate safely. But accidents are also difficult to predict; and that difficulty is not a good argument against buying insurance.  There is no doubt that there is a price to be paid for every policy action.  But the price of prematurely slowing down a debt bubble is infinitely lower than letting the bubble build until it bursts uncontrollably. In finance as in medicine, prevention is preferable to even the best cure.  All market participants know pigs lose money. And a monetary pig loses control of the economy.

Greenspan has said on several occasions that while he expected continued debate over whether the Fed could and should use its power over short-term interest rates to try to influence asset prices, he did not see that as feasible. “The configuration of asset prices is already an integral part of our evaluation of the large array of forces that influence financial stability and economic growth,” he repeated that theme in his speech at Jackson Hole, “but given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset prices any time soon.”  Yet his negative real interest rate policy since 2000 to prevent deflation was a clear policy of asset price targeting.

Volcker’s new operating method in 1980 was designed to let the monetary aggregates set the FFR targets mathematically to provide political cover for the FOMC members if the FFR target needed to go to high double digits. This was monetarism through the back door, not by intellectual commitment, but by political cowardice.  Volcker used the monetary aggregate formula to deflect political heat to stay in the monetary kitchen. Greenspan’s one-note monetary policy of relying on changing the FFR target is not based on any definitive understanding of the relationship between interest rate levels and economic growth, a deficiency he has repeatedly acknowledged not just for himself but also for the entire economics community. Yet after all is said and done, the only instrument the most powerful official in the financial world relies on to manage the world’s dominant economy is raising or lowering the FFR.

At a meeting of the American Economic Association in San Diego on January 3, 2004, Greenspan spoke on “Risk and Uncertainty in Monetary Policy” in which he asserted that Fed policies had been correct and successful in handling the bubble economy. He defended himself against criticism, saying policymakers would have damaged the economy in the late 1990s had they tried to prevent or later puncture that era’s speculative stock market bubble. It is a very peculiar position, one that would be expected from the risk manager of a commercial bank or a hedge fund, not a central banker whose job presumably is to ensure systemic stability by eliminating rather than managing, and therefore accepting systemic risk. “There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful,” Greenspan boasted prematurely. Yet twenty months later at Jackson Hole, Greenspan said: “This vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.” But the source of the mistaken view held by market participants is traceable to Greenspan’s declared refusal to prevent the bubble and to his adherence to a measured-paced interest rate policy to manage the bubble once it has become undeniable.

Greenspan, notwithstanding his denial of responsibility in helping through the 1990s to unleash the equity bubble, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”

By the next expansion, Greenspan meant the next bubble which manifested itself in housing. The mitigating policy was a massive injection of liquidity into the banking system. There is a structural reason why the housing bubble replaced the high-tech bubble.  Houses cannot be imported like manufactured goods, although much of the content in houses, such as furniture, hardware, windows, kitchen equipment and bath fixtures are mostly manufactured overseas. Yet construction jobs cannot be outsourced overseas to take advantage of wage arbitrage. Instead, some of non-skilled jobs are filled by low-waged illegal immigrants. Total outstanding home mortgage in 1999 was $4.45 trillion and by 2004 it grew to $7.56 trillion, most of which were absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding home mortgage stood only at $1.82 trillion.  On his watch, outstanding home mortgage quadrupled.  Much of this money has been printed by the Fed, exported through the trade deficit and re-imported as debt.

Greenspan went on: “During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the Federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable… … We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years. There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession - even milder than that of a decade earlier. As I discuss later, much of the ability of the US economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability.”  Structural flexibility and aggressive monetary ease are significant contributors to stability? One might as well claim that drug addiction calms nerves.

The growth of capital markets was responsible for the long boom that began with the Greenspan era in 1987, rather than bank lending. Banks’ share of net credit markets, according Fed data on flow of funds, dropped from a peak of over 62% in 1975 to 27.5% in 2004 while securitization’s share rose from negligible in 1975 to over 60% in 2004. Securitization now stands at over $3 trillion up from $375 billion in 1985.  It shows the effect of a shift of importance from banks as funding intermediaries to the capital/credit markets.  Nasdaq companies rely less on banks for funds and are thus less affected by Greenspan’s interest rate policy.  Greenspan has been vocal in explaining that his monetary policy gradual moves of rising FFR was not specifically targeted towards the stock markets but toward the unsustainable expansion of the economy as a whole, although with the same breath, he decried the dangers of the wealth effect if it ever ends up heavier on the consumption side than on the investment side, which of course was exactly what happened.  Consumer spending has been holding up the US economy in recent years, while most of the supply-side investment has gone overseas. This has caused a separation between the dollar economy and the US economy. The dollar economy expands from global dollar hegemony while the US economy is hollowed out of manufacturing. Dollar hegemony has deprived the US economy of real productivity from manufacturing and forced it into virtual productivity from finance manipulation.

It is a curious position, as most Greenspan’s positions seem to be: asset inflation is good unless it is spent by consumers rather than to fuel more asset inflation.  He continues to try half-heartedly to restrain demand in favor of supply in an economy already plagued by overcapacity. He ignores the glaring fact that supply-side investment while staying in the global dollar economy through dollar hegemony, has largely skirted the US economy, leaving it with an unsustainable debt bubble. Greenspan seems to think that it does not matter who owns the dollars the Fed prints, as long as most debts are denominated in dollars that the Fed can print at will. In a sense, he is the wizard of dollar hegemony which in addition to impoverishing all non-dollar economies, is beginning to impoverish also the US economy.

Greenspan also supported the Bush $1.3 trillion tax cut of 2001 and the additional $674 billion tax cut of 2003 which instead of helping the economy, merely shifted debt from the private sector to the public sector in the form of fiscal deficits and sovereign debt.  Instead of increasing savings from the tax cut, the private sector promptly took on more debt. The tax cut so favored the rich that the tax savings from the low-income earners mostly goes to pay interest on the loans funded by tax savings of the rich.

The so-called "bifurcated" market indexes of the late 1990s, dividing the so-call New Economy from the Old Economy, with one group of companies contributing to new highs, the other to new lows, clearly indicated that the Fed, whose sole weapon being monetary measures, had lost control of the New Economy which appeared impervious to short-term interest rates, while unable to help the Old Economy.  Under such conditions, the only way the Fed could slow the economy was to overshoot the interest rate target to try in vain to rein in an interest-impervious Nasdaq at the peril of the whole economy.  Interest sensitive stocks were battered badly, including banks and non-bank lenders, such as GE and Amex. This group of financial services companies, including commercial banks, brokerage firms and mortgage lenders, had produced some of the biggest profits in the post-1987-crash bull market.  The combination of rising interest rates and the hefty leverage on the books of these businesses proved hazardous to their stock prices. Money center banks and broker dealers were most vulnerable because they were the most exposed to interest-rate-related products such as swaps and mortgages.

The most popular of all derivative products is the interest rate swap, which essentially allows participants to make bets on the direction interest rates will take. According to the Office of the Comptroller of the Currency (OCC), interest rate swaps accounted for three out of four derivative contracts held by commercial banks at the end of 1999. The notional value of these swaps totaled almost $25 trillion; 2-3% of that ($500-750 billion) reflected the banks’ true credit risk in these products. Monetary economists have no idea if notional values are part of the money supply and with what discount ratio. As we now know from experience, creative accounting has legally and illegally transformed debt proceeds as revenue.

The OCC 2005 Report on Condition and Performance of Commercial Banks shows that loan demand grew at 11% in Q1 2005 while core deposit grew at 7%, producing a 4% gap. That meant that banks loan growth was not fully funded by deposits. The report identified possible risks as: cooling off in housing markets has accompanied slower loan growth; past regional housing price declines have lingered; credit quality problems in housing have spilled over to other loan types.  Not a comforting picture.

Derivatives of all kinds weigh heavily on banks’ capital structures. But interest rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began while yields in fact rose 25%, these institutions found themselves on the wrong side of an interest rate gamble by 2000.  Moreover, as interest rates rose, banks’ income diminished from interest-rate-related businesses, such as mortgage lending.  Interest-sensitive sources of income were the revenue disappointment in 2000, as trading was in 1999.  The banks’ response was to lower credit requirement for loans.

When Treasury yields were at their highest levels before the Treasury under Larry Summers launched its long-term debt buybacks in 2000, rate increases from the Fed seemed a consistent if not rational policy. Stock investors in the Old Economy did not get spooked by the expected rising rates. But when the gap between the Treasury and the Fed left Telephone bonds at 8.22% while 30-year treasuries at 6.14% (5.38% a year earlier), investors jumped ship.

Moreover, even as the Nasdaq suffered a substantial correction, its impact on the wealth effect was not expected to be total.  Major investment banks had been pitching to high-tech/internet founders and early shareholders to hedge their multi-million dollar winnings to-date by signing away their future upsides to risk investors.  So, for many high-tech swimmers, this amounts to second layer swimming trunks on which they can depend and not risk being caught naked when the tide receded suddenly.  Unfortunately, much of the diversification stay within the New Economy where high returns from capital gain could be achieved. It was the financial version of a flat-proved tubeless tire that can get the motorist to the next gas station or 30 miles (whichever is closer) in the event of a puncture.  It does not, however, guarantee the driver the existence of a gas station that has not been forced into bankruptcy within 30 miles.  It does not protect the motorist from a systemic collapse.  Greed always neutralizes fear.

There was a near total disconnect between the old and new economies in 1999.  The DJIA was falling, according to analysts, because of investor disappointment over earnings, which would be further impacted adversely by rising interest rates. Yet the Nasdaq remains impervious to both interest rate hikes and near-perpetual negative earnings.

Globally, other markets were catching the Wall Street greed affliction.  Hong Kong, which traditionally followed US markets because of its currency peg to the dollar and its exports reliance on US markets, saw the HSI shoot through 17,000 (coming from a low of 6,600 in August 1997) while the DOW broke above 9,000, primarily because of a tulip-like hysteria on Internet startups and telephone mergers.  One grandmother in Hong Kong was reported to have asked a 20-year-old broker what the Internet was while she was writing out a six-figure check to buy the IPO shares of an Internet startup. It was not likely that the company she was investing her retirement money in would show a positive cash flow in her life time.  The odds were that the longevity of the grandmother was greater than that of the new company.

Meanwhile, back in the US, mutual funds were forced to jettison their old fashioned balanced portfolios in favor of all tech strategies. In one week in 1999, $1.6 billion additional went into high tech funds, $1.2 billion went into bio-tech, and $1 billion into aggressive growth funds.  S&P 500-linked funds lost investors. Greenspan made his famous "irrational exuberance" speech at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research in Washington, DC on December 5, 1996, when the DJIA was at 6,437. On January 14, 2000, the DJIA peaked at 11,723, and on March 16, 2000, the DJIA experienced its largest one-day point gain in history - 499.19 points - to close at 10,630.60. On April 14, 2000, 22 trading days later, the DJIA plummeted 617.78 points, closing at 10,305.77 - its steepest point decline in a single day historically so far. This volatility came purely from speculative forces finance by debt. The economy did not change in 22 trading days.

Now, who are the investors in the Old and New Economies?  Institutions such as pension funds and endowment funds, are prevented by law or internal rules to detach themselves from broadly based portfolios, when “qualified investors”, those with net worth is over $2 million or more, depending on SEC definition, are the investors in the New Economy. Many who gained from the rise of the New Economy used their new wealth to acquire assets in the old economy at fire sale prices and the excess brought down both the Old and New Economies.  Investors in the Old Economy did not benefit from the speculative rise of the New Economy, but they nevertheless had to pay for the losses.

Illustrating the merger of the New and Old Economy, American Online (AOL) announced on January 10, 2000, a merger with Time Warner Inc, paying $182 billion for the media giant. The offer from AOL, whose market value was $163 billion, valued Time Warner at a premium of $164.75 billion, about double the target company’s $83 billion market capitalization at the close of market trading. The Federal Communication Commission approved a $350 billion merger between AOL and Time Warner a year later on January 19, 2001. Two years later, on January 30, 2003 AOL-Time Warner reported a $45.5 billion quarterly loss to account for the declining value of its flagship America Online property, bringing the company to post an annual loss of nearly $100 billion, the largest annual loss ever in corporate history.

From the start of 2002 until the end of the same year, the NASDAQ composite index fell 49.5%. The S&P 500 dropped 23% in 2002. On December 31, 2002, the NASDAQ was 80% below its peak in 2000. From 2001 through March of 2003, the total number of civilian jobs rose only 0.3%, against an average annual increase of 2.4% during the 1990s. The US lost 1.5 million non-farm jobs from 2001 to March 2003, a drop of 1.2%. Unemployment rose to 6%. What Greenspan did was to punish the general public by devaluing their future pension and cash flow, to pay for the sins of the aggressively investing rich who continue to add to their wealth with Greenspan’s blessing as long as the ill-gained riches from speculation are reinvested for more speculation for more ill gains.

The alleged "recovery" of the stock market in 2003 - with the DJIA rising by 25% from its low in March, the Nasdaq rising a phenomenal 50 percent, the S&P 500 rising 26% and the Russell 2000 rising 45% - was tempered by the dollar falling 20% against the euro, 10% against the yen despite BOJ intervention, and a whopping 34% against the Australian dollar on rising demand on gold, iron ore and other commodities produced there. This explained why it was a jobless recovery.

On Greenspan’s 18-year watch, GSE (Government Sponsored Enterprises) assets ballooned 830%, from $346 billion to $2.872 trillion. GSEs are financing entities created by Congress to fund subsidized loans to certain groups of borrowers such as middle and low-income homeowners, farmers and students. Agency MBS (mortgage-backed securities) surged 670% to $3.55 Trillion. Outstanding ABS (Asset-backed securities) exploded from $75 billion to today’ more than $2.70 trillion.  Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge fund industry, bloated Wall Street firm balance sheets approaching $2 trillion, a $3.3 trillion repo market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion. Granted notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, approximately 20% of US GDP.

Under Volker’s new operating method in 1980, banks became vulnerably exposed to risks that interest rates might suddenly and drastically go against even their short-term credit positions. Also, banks had been expanding new loans beyond the growth of deposits, by borrowing shorter-term funds at lower interest rates. This practice was given the benign label of “managed liability”, allowing banks to profit from interest-rate spreads over the yield curve, which had seldom been allowed by the Fed to get inverted, that is, with short-term rates higher than longer-term rates. Because of the large size of outstanding long-term debts in the credit market, long-term interest rates are normally set by supply and demand.  Moreover, long-term debts are issued by the Treasury and by private enterprises, not by the Fed.  The Fed’s power over interest rates is limited to the overnight Fed funds rate which defines the annualized short-term cost of borrowings between banks.

This practice of borrowing short-term at low interest rates to lend long-term at higher interest rates, known as "carry trade" in bank parlance, when globalized by deregulated cross-border flow of funds, eventually led to the Asian financial crisis of 1997 when interest-rate and exchange-rate volatility became the new paradigm. Today, there are undeniable signs that the same interest rate risks have infested the housing bubble in recent years.  And the Fed’s traditional gradualism, now revived as “measured pace” in raising the FFR targets in response to rapid asset price inflation has had little effect in curbing bank lending to fund rampant speculation.  In recent months, Greenspan has repeatedly denied the existence of a national housing bubble by drawing on the conventional wisdom that the US housing market is highly disaggregated by location, which is true enough.  Disaggregated markets are normally not exposed to contagion, a term given to the process of distressed deals dragging down healthy deals in the same market as speculator throw good money after bad to try to stem the tide of losses. But the bubble in the housing market is caused by creative housing finance made possible by the emergence of a deregulated global credit market through finance liberalization. The low cost of mortgages lifts all house prices beyond levels sustainable by household income in otherwise disaggregated markets.  Under cross-border finance liberalization, negative wealth effects from asset value correction are highly contagious. For example, the Dallas Fed Beige Book released on July 27, 2005 states: “Contacts say real estate investment is extremely high in part because the District’s competitively-priced markets are attracting investment capital from more expensive coastal markets.”  The nation-wide proliferation of no-income-verification, interest-only, zero-equity and cash-out loans, while making financial sense in a rising market, is fatally toxic in a falling market, which will hit a speculative boom as surely as the sun will set.  Since the money financing this housing bubble is sourced globally, a bursting of the US housing bubble will have dire consequences globally.

Volker’s new operating method in 1980 greatly increased the banks’ risk exposure to interest rate volatility.  Volcker also set an additional 8% reserve on borrowed funds for lending, on top of the normal 10% required, to curb the creation of money through partial-reserve banking lending and thus to slow the growth of the monetary aggregate. In 1980, the repos market was not a significant factor. A quarter of a century later, a 2002 study by the NY Fed shows banks now appear to be managing their cash inventories less to comply with regulatory reserve minimums than to meet business needs with borrowed funds, mostly from the repo market.<>

In the age of finance globalization, exchange rate movements have become a critical channel through which monetary policy affects the economy, and they tend to respond promptly to a change in the provision of reserves and in interest rates. Information on exchange rates, like that on interest rates, is available almost continuously throughout each day in the repo and futures markets.

Interpreting the meaning of movements in foreign exchange rates, however, is not always straightforward. A decline in the foreign exchange value of the dollar, for example, could indicate that monetary policy had become more accommodative, with possible risks of inflation. But foreign exchange rates respond to other influences, such as market assessments of the strength of aggregate demand or developments abroad. For example, a weaker dollar on foreign exchange markets could instead suggest lessened demand for US goods and decreased inflationary pressures. Or a weaker dollar could result from higher interest rates abroad—making assets in those countries more attractive—that could come from strengthening economies or the tightening of monetary policy abroad.  US inflation rate has been held down by low-price imports. A fall in the exchange value of the dollar will lead to inflationary pressures in the US.  The distortion of the exchange rate of the market by dollar hegemony is substantial.

Determining which level of the exchange rate is most consistent with the ultimate goals of policy can be difficult if not impossible. Selecting the wrong level could lead to a sustained period of deflation and high levels of economic slack or to a greatly overheated economy. As the Treasury views a strong dollar as a matter of national interest, the exchange rate of the dollar in an otherwise free market is viewed by the US as a matter of national security, on which the Fed is obliged by law to defer to the Treasury. Also, reacting in an aggressive way to exchange market pressures could result in the transmission to the US of certain disturbances from abroad, as the exchange rate could not adjust to cushion them. Consequently, the Fed does not have specific targets for exchange rates but considers movements in those rates in the context of other available information about financial markets and economies at home and abroad. However, the debt-driven US economy requires a strong dollar to keep foreign lenders from selling the dollar debts they hold.  Exchange rate policy is set by the Treasury as a matter of national economic security to which the Fed is obliged by law to support.

Knowing that, the Fed is engaging in self-delusion when it relies on a measured-paced interest rate policy to deal with a run-sway debt bubble sourced globally.  For the Fed, the debt bubble is already too big to burst. The only option is to keep feeding it albeit at a slower pace. The measured-pace interest rate policy is merely an attempt to slow the bubble’s rate of expansion, not to stop it, much less to burst it.  But a measured-paced interest rate policy will slow down the economy enough for a soft landing. It will only prolong the bubble for a bigger bang at the end.  What Greenspan did at Jackson Hole was to give warning that the end is at hand.

Through mortgage-backed securitization, banks now are mere loan intermediaries who assume no long-term risk on the risky loans they make, which are sold as securitized debt of unbundled levels of risk to institutional investors with varying risk appetite commensurate with their varying need for higher returns.  But who are institutional investors? They are mostly pension funds who manage the money the working public depends on for retirement. In other words, the aggregate retirement assets of the working public are exposed to the risk of the same working public defaulting on their own house mortgages. When a home owner loses his/her home through default of its mortgage, the home owner will also lose his/her retirement nest egg invested in the securitized mortgage pool while the banks stay technically solvent.  That is the hidden network of linked financial land mines in a housing bubble financed by mortgage-backed securitization to which no one is paying attention.  The bursting of the housing bubble will act as a detonator for a massive pension crisis.

Next: The Repo Time Bomb